Other Factors Affecting Price: More than just the creditworthiness of the issuing corporation influences a bond's price. Returns available from alternative investments, the rate of inflation, and the time line for interest payments and return of principal are also significant factors.

As a general rule, the longer the time to maturity (the date on which the borrower must pay back the principal), the more volatile a bond's price is likely to be. In addition, investors typically require a higher interest rate for long-term debt, whose principal is not expected to be repaid for many years, than they do for short-term debt. This is to compensate them for the greater amount of time that their funds are tied up and for the uncertainty involved.

In large part, interest rates reflect an assumed level of inflation plus a premium for various kinds of risk that lenders take. Unlike cash dividends from stocks, interest payments from bonds (usually distributed semiannually) typically remain fixed over the entire life of the bond. A $100 interest payment received three years from now, however, is not likely to have as much purchasing power as a $100 payment received tomorrow. Therefore, investors generally require a higher yield from longer-term securities. Typically, bond prices rise during periods in which expectations of inflation lower. Conversely, when investors expect inflation to rise, bonds become less attractive to investors and prices generally decline. The returns from fixed-income investments tend to weaken during periods of high inflation (e.g., 1974, 1979 and 1980, when inflation was at a double-digit annual rate). The returns from U.S. Treasury bills are less volatile, in both directions. This is because, with investors due to receive their return of principal sooner than they will from long-term bonds, erosion of purchasing power, or inflation, is less of an issue.

An attractive feature of bonds (particularly those of higher-quality issues) is the relatively predictable flow of interest and principal payments. The sensitivity of bond prices to changes in the general interest rate environment presents an element of risk to bond traders, however. For example, if an investor elects to sell a bond prior to maturity and interest rates have risen since the bond was purchased, its market price probably will have declined. Alternately, an investor will likely be able to sell at a profit if interest rates have declined.

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Reinvestment Rate Risk: If a bond is held to maturity, interim changes in interest rates and bond prices are likely to be less of a concern than if a bond is sold prematurely. However, reinvestment rate risk is a consideration, and that is influenced by changes in interest rates and bond prices. An investor may not be able to reinvest cash returns from an investment at the same level of return with the same amount of risk. This uncertainty about what kinds of returns will be available in the future is the reinvestment rate risk. Thus, even investors who hold bonds to maturity must ultimately face up to changes in the interest rate environment.

For example, during a period when an investor is receiving a 9% annual yield ($90 a year from a $1,000 bond), the interest rate environment may change to the extent that a new buyer of the same bond will receive only a 7.5% yield. Thus, the first investor will not be able to put the $90 to work at the same 9% level unless he or she is willing to assume more risk. Conversely, if rates have risen, it will be possible to invest the $90 at a higher rate of return.

One way many large investors cope with reinvestment rate risk is to establish a rolling bond portfolio. Such a portfolio includes bonds with varying maturity dates, so the whole portfolio won't roll over at once. For example, an investor with $100,000 to be invested in tax-free bonds might purchase ten $10,000 bonds with maturities spaced every 2 years, ranging from 2 years to 20. Not only does this diminish reinvestment rate risk, but it also achieves a blended yield of both shorter-term and longer-term returns. In addition, the staggered maturities provide automatic liquidity (from repayment of principal) without having to sell into the market; that is, some money is available every two years.

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Some Types of Bonds Callable bonds:. Many bonds have call features, which give the issuer the right to retire the bond prior to maturity. In such cases, the issuer is enabled, during specific time periods, to call, or repurchase, a bond away from its owner at a preset price that represents a small premium. The action is entirely at the election of the issuer, with no recourse to the holder. Most federal government bonds are not callable; corporate and municipal bonds usually are.

Issuers like the call feature because it gives them opportunities to refinance portions of their debt if interest rates decline. For example, a 20-year corporate bond might be issued at a rate of 11% with a provision that it can be called away from holders after five years at a price of $104 per $100 of principal value. If, five years later, the interest rate for similar bonds has dropped to 8.5%, the issuer would probably find it favorable to call the old bond and replace that debt with a new, and much cheaper, 8.5% bond.

Because of call features, bond investors can be hurt by both rises and declines in interest rates. Regardless of call features, when rates increase, the value of a bond will typically fall, as a means of adjusting its effective yield to that of alternative investments. In addition, a callable bond presents a further problem if interest rates decline enough, perhaps two or three percentage points. In such cases, a callable bond will probably be repurchased from its owner. If that occurs, the investor will be unlikely to find another security of similar quality that will provide as high an income stream.

In addition to looking at characteristics such as creditworthiness and liquidity, therefore, prospective investors should always check on whether a bond is callable and under what terms. Because of this feature, the cash flow stream on callable bonds is somewhat unpredictable.

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Convertibles:. One way of counteracting the risk of inflation is to buy bonds or debentures that are convertible into stocks. These securities typically provide many of the safeguards inherent in nonconvertible debt securities yet permit the holder to exchange his or her bond for a specified number of common shares. The advantage of this type of bond is that if the stock price rises, the bond is likely to rise in value also. This kind of upside potential is part of convertible bonds' appeal. Because of this feature, however, a premium must be paid for such bonds: They offer a lower interest rate than regular issues of comparable quality and maturity.

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Zero-Coupon Bonds: Zero-coupon bonds pay no interest until maturity; rather, they are sold at a deep discount from face value and gradually achieve their face value over time. For example, a bond with a $1,000 face value intended to yield 8% over 15 years would be sold initially for about $315. With a zero-coupon bond, you can lock in a relatively assured yield to maturity without having to worry about reinvesting cash interest payments at varying rates in the future. Nonetheless, although the bond owner does not actually receive the cash until the obligation matures, income tax is owed on the implicit interest that accrues each year. Thus, for individual investors, zeros are primarily suitable for IRAs, Keogh plans, and other kinds of tax-sheltered accounts. The most popular zeros are those backed by Treasury obligations.